|July 18, 2018|
The unacceptable logic of the markets
|Is climate change downgrading the sovereign credit ratings of climate-vulnerable countries? Is climate vulnerability increasing the rate of interest on sovereign debt? Is the insurance industry refusing to insure climate-vulnerable assets? If this is true,the market is victimising the victims of climate change. Let me explain.|
Developing countries, especially least developed countries and island countries, are most vulnerable to climate change, but they have contributed the least in causing climate change. The Global Climate Risk Index, which ranks countries based on the losses they have suffered due to climate-related events (storms, floods, heatwaves), finds developing countries the worst affected due to climate change. The Global Climate Risk Index 2017 has ranked India the fourth worst-affected country.
But, the contribution of developing countries in total greenhouse gas emissions is very low compared to developed countries. For instance, since 1850, the contribution of India to global carbon dioxide emissions is less than 5%, while it is over 20% for the US and the EU. Yet, a new report commissioned by UN Environment indicates that countries that are highly vulnerable to climate change are paying a high cost for sovereign borrowing, above and beyond the rates attributable to macroeconomic and fiscal fundamentals. I will come back to this report later.
Rising cost of climate catastrophes
The fact is that losses due to climate change are fast increasing. According to Swiss Re, the world's second-largest reinsurer, the frequency of climate-related catastrophes has increased six-fold since the 1950s.The economic losses due to these catastrophes havr grown more than five-fold since the 1980s.The year 2017 was in fact the most expensive year on record, with total losses due to severe weather and climate events reaching $320 billion. So far, we have, in 2018, already witnessed a large number of billion-dollar-loss events---bitter winter storms in Europe and North America, extreme heatwaves in Australia, Canada and Argentina, acute water shortages in Cape Town and a devastating flood and landslides in Japan that killed more than 200 people. According to the insurance industry, the losses are now so high that previously insurable assets are becoming uninsurable, or those already underinsured are not likely to be insured by the industry. This is widening the climate risk-protection gap---the gap between economic losses and insured losses.
This gap is already high in the developing countries, where most assets are uninsured, but is now growing rapidly in developed countries as well. A recent analysis by Swiss Re found that, on average, only about 30% of catastrophe losses are covered by insurance. The remaining losses are borne by governments, companies and individuals. The climate risk-protection gap now stands at $100 billion annually. In normal circumstances, this gap would continue to grow as insurance companies would either avoid risky assets or charge very high premium thereby making insurance unaffordable to large sections of the society, especially in developing countries.
The unacceptable logic
The financial market is also using the same logic. The report of the UN Environment---Climate Change and the Cost of Capital in Developing Countries---found that that climate vulnerability has already raised the average cost of debt in a sample of 25 vulnerable developing countries by 117 basis points. In absolute terms, this translates into $40 billion in additional interest payments over the past 10 years on government debt of these countries alone. In other words, for every $10 paid in interest by developing countries, an additional dollar is spent due to climate vulnerability. The report projects that the magnitude of this burden will at least double over the next decade.
The report also found that, so far, major credit rating agencies have not downgraded the credit ratings of countries due to climate risks. But this is largely because the major rating agencies do not generally itemise climate risks in their assessment methodology and hence do not separately mention climate vulnerability in their country assessment reports. This, however, does not mean that they are not capturing climate risks in their assessment. They are, but under different assessment criteria. Major credit rating agencies are, meanwhile, now contemplating including climate-related risks in their assessment. Considering that climate change is a downside risk, its inclusion in the sovereign rating will almost certainly be negative for most developing countries.
The logic of the insurance industry to not insure highly climate-risky assets and that of the financial industry to increase the rate of interest for climate-vulnerable countries is the same---the higher the risk, the higher is the cost. But this traditional logic is making climate-vulnerable countries more vulnerable and is transferring the costs of climate change to the world's poorest. This is unacceptable. So, how do we ensure that the financial market and insurance industry work in favour of the most vulnerable and not against them? ClimateWise, a global network of 29 insurance industry organisations, is proposing closing the climate risk-protection gap by supporting greater investments by the insurance industry in building resilience against climate change. The logic is that the higher the resilience of a society, the lower is the risk to the insurer.
The insurance industry has over $30 trillion in invested capital. This is a great leverage to support the transition to a low-carbon, climate-resilient economy. Several international insurers have already announced disinvestment from fossil fuel-intensive assets and as the impacts increase, many are likely to follow suit. Similarly, support of the insurance industry for green bonds and investments in resilience-enhancing infrastructure will go a long way in building the resilience of vulnerable countries and reducing the risk of insurance companies---a win-win for developing countries and the insurance industry.
The financial industry will also have to do the same. Instead of penalising countries for their vulnerability to climate change, they should promote investments that enhance the resilience of climate vulnerable countries. The same holds true for credit rating agencies. Instead of considering climate change a downside risk in their assessment criteria, they should consider investments in enhancing the resilience against climate change as an upside opportunity. This will encourage developing countries to invest in building resilience, which will improve their sovereign credit ratings and bring down their cost of borrowing.